When businesses expand, they must increase liabilities or investments. The company’s financial position and the amount needed are determining factors. Current ratios provide an indication of a company’s ability to pay its debts, and the ratio of liabilities to equity indicates the better choice of adding debts or seeking investors.
Current Ratio
The current ratio is calculated by dividing the current assets by current liabilities.
Current asset accounts are cash, receivables and marketable securities that mature within one year.
Current liabilities are accounts payable and notes payable due within one year.
A current ratio of 2:1 indicates the entity has $2.00 in assets for each dollar it owes.
Credit Lines
Every business develops credit lines to finance daily transactions and capital improvements. These credit lines include financial institutions, suppliers and credit cards. Businesses may also use short-term credit for buying equipment. These are liabilities.
Merchant accounts, however, have an additional credit line provided by credit card processing companies. These companies buy credit card receivables at a discount and collect the payments when paid by the card user. Under normal circumstances, businesses use the cash and forget cash advances.
Cash Flow
Planning cash flow allows businesses to optimize investments and purchasing power. With proper planning, businesses borrow less and pay less interest. Using the current ratio as a guide, cash flow planners can more readily recognize surpluses for investment or points at which loans will be required.
Despite the best planning, owners have emergencies that require unexpected expenditures. In these situations, the owner should check credit lines for possible financing. These unexpected expenses are ideal for merchant accounts and credit card processing companies.
Why Add Investors?
Assets are divided between creditors and owners. The ratio is calculated by dividing total assets by equity. The ratio should be less that 1:1.
When incurring new debt, planners should add one-year’s payments to the current liabilities. Calculating the current ratio reveals the affordability of the debt. If the ratio is less than 1:1, the business should consider new investment.
By adding the new debt to total liabilities and dividing by equity, planners can determine the new ratio. A ratio of more than 1:1 indicates new investment may be required.
Planners should do additional cash flow and credit analysis before making a decision.